Up until very recently, we’ve all been watching the almost daily pronouncements of new all-time highs in both the S&P 500 and the Dow Jones Industrial Average. But many investors may be in for a rude awakening: an account statement that shows an annual return less than the major indexes—and less than what the investor expected. The reason may surprise you, too: diversification.
That’s right. The advice that was drilled into your head for your entire investing career, whether you are new to investing or have been at it for decades, held you back this year.
Investors all too often go by the news they see, hear and read. And since financial news is almost entirely focused on the three major large-cap stock indices—the DJIA, S&P 500 and NASDAQ Composite—many investors may not be tracking other parts of the stock market, which in many cases did not perform nearly as well as their large-cap brethren.
Just take a look at some of the major asset classes that are either barely up for 2014 or are in negative territory: high-yield (junk) bonds, small cap, commodities, metals, energy, and international and emerging market equities have either barely moved or lost ground this year. And so if you are following any kind of standard pie chart of asset allocation, you may feel like you missed out on what could have been a big boost to your investment returns.
“This year could easily be one that leaves investors thinking that diversification is a hindrance to investment performance.”
And it gets even worse! Shares of some of the largest and most widely held companies are flat or negative for 2014, too. That’s obvious in the energy sector, for sure. But in almost every major market sector, this situation is particularly pronounced this year. And if you separate the value stocks from the growth stocks within the S&P 500, value lagged growth by nearly 50 percent.
Investors’ patience is tested when some of their holdings are not powering higher when the major averages are surging. In fact, this year could easily be one that leaves investors thinking that diversification is a hindrance to investment performance. Well, before anyone tosses diversification out the window after reviewing their 2014 year-end statement, let’s have a quick back-to-basics conversation.
1. Risk-adjusted return is a worthy goal.
In other words, a return level that is appropriate for you based on your risk tolerance, time horizon and investment goals isn’t necessarily one designed to beat the index every year. The operative word here is “risk.” Yes, the more risk you take means the higher your potential returns should be. But there are limits to that, because eventually you’ll probably need to start cashing in on your investments, which shortens your time horizon.
2. Eventually, every winner becomes a loser.
Whether you are paying an advisor or you are investing on your own, investing is comparable to a long-term journey of course correction. Rebalancing your portfolio by reducing winning positions and reinventing the proceeds into losing positions may seem counterintuitive, but it is important not to let one asset class overrun the rest of your investment portfolio. Eventually, every winning asset class will become a drag and vice versa for the current laggards.
Sectors are a good example of this. I clearly remember the tech boom of the late 1990s. The more recent disaster in financials and industrials came in the 2007 to 2009 market crash. Now the energy complex is tanking. All of these sectors were the market darlings just before the pummeling took place. And after each crash, I always meet investors who were financially hurt because they had too much exposure to these sectors. It makes no more sense to avoid any of these sectors as it did to overload them, but how about taking a little off the table once in a while and reinvesting elsewhere? These investors may have had more discipline at an earlier point in their investing careers, but like everything else, it takes discipline to stay disciplined!
3. Your investing “normal” should not be to expect, or hope, everything goes up or down at the same time.
The basic premise is that over long periods of time, all asset classes are expected to produce a positive return; it is just that they often do so at different times over the short and intermediate time. The different components in your investment account shouldn’t be expected to go up and down at the same time. If that happens, it means your account holdings are “correlated,” which means your investments are moving up and down in tandem. I like to say to my clients that we have an “all-weather portfolio” as opposed to a bull market portfolio. This means that by definition, the components in a portfolio have to be non-correlated to be truly diversified.
Stick with the conservative swing
Now is the time to review your underperforming investments and potentially add to those. Uncovering value in securities with substantial gains in someone else’s portfolio is tough to do, in my opinion. And most importantly, please remain diversified.
Diversification is not a strategy that is all about shooting out the lights; it is about avoiding the big setbacks along the way to help you meet your goals. It doesn’t guarantee a profit. It doesn’t necessarily protect against losses in declining markets. It is a method used to help manage investment risk. And spending more time aboveground running is preferable to spending more time climbing out of holes. That’s very similar to golf: You lower your score by avoiding hazards and reducing mistakes as opposed to swinging the club like the Sunday slam each time you’re over the ball.
—By Mitch Goldberg, president of ClientFirst Strategy